Cost Basis of Rental Property: Adjustments, Conversions, and Sale

The cost basis of a rental property is what you have invested in it for tax purposes: the purchase price, plus qualifying acquisition costs, plus capital improvements you make over time, minus depreciation you claim (or were entitled to claim) and a few other reductions. That single number drives your annual depreciation deduction and your taxable gain when you sell, so it is worth building carefully from the closing statement forward and adjusting each year you own the property.

What Goes Into the Starting Basis

Basis starts with the price you paid the seller. To that, you add certain settlement costs tied to acquiring the property itself. The IRS separates acquisition costs (which increase basis) from financing costs (which do not).¹

Costs that increase your starting basis include:

Legal fees for the title search, contract preparation, and deed recording
Owner’s title insurance premium
State or local transfer taxes on the property transfer
Survey fees required for closing
Recording fees charged by the county

Costs that do not increase basis include loan origination fees, mortgage points, and appraisal fees charged by your lender. Those are financing costs, handled either as amortized loan expenses or as interest.¹

A seller credit reduces your basis. If the seller credited you $5,000 toward closing costs or repairs, that credit lowers what you actually paid, and your starting basis drops by the same amount. If instead you agreed to pay something that was legally the seller’s obligation, like unpaid back taxes, add that amount to basis.

Money you spend to make the property ready for its first tenant, such as cleaning, minor repairs before it is placed in service, and utility hookups, also gets folded into the starting basis rather than deducted as a current expense. Once you total all of this up, you have your initial cost basis, and you can move to allocating it.

Splitting the Basis Between Land and Building

Land is not depreciable. The tax code allows depreciation only on the building and its structural components, because land does not wear out.² Before you can calculate a single year of depreciation, you have to split your total cost basis into a land portion and a building portion.

The common approach uses the local property tax assessment. Most jurisdictions assess land and improvements separately, so you apply that same percentage split to your cost basis. If the assessor puts the land at 20% and improvements at 80% of total value, allocate 20% of your basis to land and 80% to the building.

A professional appraisal is the stronger alternative if the assessment looks off or if you are buying in an area where land values are unusually high relative to structures. Whichever method you pick, the IRS expects the split to be reasonable. An allocation that quietly minimizes land value to inflate the depreciable portion will not hold up.

The building portion of your basis is what enters the depreciation calculation. Residential rental property uses the straight-line method over a 27.5-year recovery period.²

What Increases Basis After You Buy

Every dollar you spend on the property after purchase falls into one of two buckets. Repairs keep the property in its current condition (fixing a leaky faucet, patching drywall, replacing a broken window) and are deducted in the year you pay them. They do not touch basis.

Improvements are different. Under the IRS tangible property regulations, you must capitalize any expense that constitutes a betterment, restoration, or adaptation of the property.³ A betterment corrects a pre-existing defect, enlarges the property, or materially increases its capacity. A restoration returns a worn-out property to working condition or replaces a major component. An adaptation converts the property to a new use. A new roof, a full kitchen remodel, or a room addition all qualify. Each capitalized improvement increases basis and begins its own 27.5-year depreciation schedule.

Safe Harbors for Smaller Expenditures

Two elections let small landlords deduct items that would otherwise have to be capitalized.

The de minimis safe harbor lets you deduct items costing $2,500 or less per invoice (or $5,000 if you have audited financial statements) instead of capitalizing them. A new $800 dishwasher or a $1,200 water heater can simply be expensed.³

The safe harbor for small taxpayers applies if your average annual gross receipts are $10 million or less and the building’s unadjusted basis is under $1 million. It lets you deduct repair and improvement costs up to the lesser of 2% of the building’s unadjusted basis or $10,000.³

Both elections have to be made annually on your tax return. When they apply, they turn what would be decades of depreciation into a current-year deduction. Everything else that is a genuine capital improvement stays on your basis worksheet. Keep every invoice; without documentation, you cannot claim the higher basis at sale.

What Decreases Basis Each Year

Basis is not static. It falls every year by the depreciation you take, and it can fall for other reasons too.

The single most important rule to understand: your basis is reduced by the depreciation that was allowed or allowable, whichever is greater.⁴ If you forgot to claim depreciation for three years, the IRS still treats your basis as if you had. Skipping deductions now does not preserve a higher basis for later. If you have been missing depreciation, Form 3115 lets you catch up through a change in accounting method rather than losing those deductions entirely.

Basis also decreases for uninsured casualty losses you deduct (storm damage, fire damage) and for certain energy or rehabilitation tax credits that require a corresponding basis reduction.⁵

Put together, the formula for adjusted basis at any point in time is: starting basis, plus capitalized improvements, minus accumulated depreciation, minus casualty loss deductions and credit-related reductions.

Inherited Rental Property

Inherited property gets a stepped-up basis equal to the property’s fair market value on the date the previous owner died.⁶ Prior appreciation is wiped out and the depreciation clock resets. If your parent bought a rental for $150,000 and it was worth $400,000 at their death, your basis is $400,000, not $150,000 minus decades of depreciation.

The fair market value usually comes from a qualified appraisal near the date of death, or from the value reported on Form 706 if an estate tax return was filed. When Form 706 is filed and the IRS accepts the reported value, that value is binding for basis purposes.

The executor can elect an alternate valuation date six months after the date of death, but only if doing so decreases both the total estate value and the estate tax owed.⁷ The election is irrevocable. If the property fell in value during those six months, the alternate date can leave the heir with a lower stepped-up basis, which is worth flagging to the executor before it is filed.

Gifted Rental Property

Gifts do not get the same reset. When someone gives you a rental property, you generally take over their adjusted basis: whatever they paid, plus improvements, minus depreciation they claimed. This is called a carryover basis.⁸

If the property’s fair market value at the time of the gift was lower than the donor’s adjusted basis, a dual basis system applies:¹

For calculating gain, use the donor’s adjusted basis
For calculating loss, use the lower fair market value at the time of the gift
If the sale price falls between those two figures, no gain or loss is recognized

Suppose the donor’s adjusted basis was $200,000 and the fair market value at the time of the gift was $170,000. Sell for $220,000 and your gain is $20,000, measured from the $200,000 donor basis. Sell for $160,000 and your loss is $10,000, measured from the $170,000 FMV. Sell for $185,000 and you have no gain or loss.

For depreciation on gifted property held for business use, you use the donor’s adjusted basis as your starting point.¹

Converting Your Home Into a Rental

Converting a personal residence into a rental creates a split basis. For depreciation, use the lower of your adjusted cost basis or the property’s fair market value on the date you place it in service as a rental.⁵ This keeps you from depreciating a decline in value that happened while you lived there.

Say you bought your home for $300,000 and put $40,000 into improvements, for a $340,000 adjusted basis. If the home is worth $290,000 when you convert it to a rental, your depreciation basis is $290,000. Allocate that between land and building as usual before running the 27.5-year calculation.

At eventual sale, the gain and loss calculations use different basis figures:

Gain basis is your original adjusted cost basis (the $340,000 in the example), minus depreciation taken
Loss basis is the fair market value at conversion ($290,000), minus depreciation taken

Between those two numbers is a zone where you sell at a nominal loss from your original investment but cannot claim it, because the drop happened during personal use. Get an appraisal on the conversion date. That one document supports your depreciation basis and every downstream calculation.

Property Acquired in a 1031 Exchange

A 1031 like-kind exchange defers capital gains tax by carrying your old basis forward rather than giving you a fresh one. The basis of the replacement property equals the basis of the property you gave up, decreased by any cash you received and adjusted for any gain or loss recognized on the exchange.⁹

In practice, if you exchange a property with a $200,000 adjusted basis for one worth $350,000 and pay $150,000 in additional cash with no boot received, your basis in the new property is $350,000: the $200,000 carryover plus the $150,000 of new money. Depreciation splits accordingly. You continue depreciating the carryover portion over the remaining life of the old asset, and the new money starts a fresh 27.5-year clock.

If you received cash or other non-like-kind property (boot), you recognize gain to that extent, and your basis adjusts upward by the gain recognized. A 1031 exchange does not reset basis; it defers tax by preserving a lower basis in the replacement property.

Why the Number Matters at Sale

The whole point of tracking basis carefully is what happens when you sell. Your taxable gain is the sale price (minus selling costs) less your adjusted basis. A higher, well-documented basis produces a smaller gain.

The depreciation you claimed along the way comes back into the calculation separately. The IRS recaptures depreciation as unrecaptured Section 1250 gain, taxed at a rate of up to 25%, and reports it through Part III of Form 4797.¹⁰ Because the allowed-or-allowable rule reduces basis by depreciation you should have taken even if you did not, skipping deductions does not save you from recapture. It just costs you the deductions.⁴ Claim depreciation every year, capitalize what has to be capitalized, keep the invoices, and your basis will hold up when it matters.

1
Internal Revenue Service. Publication 551 (12/2025), Basis of Assets
2
Office of the Law Revision Counsel. 26 USC 168 Accelerated Cost Recovery System
3
Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
4
Office of the Law Revision Counsel. 26 US Code 1016 – Adjustments to Basis
5
Internal Revenue Service. Publication 527 (2025), Residential Rental Property
6
Office of the Law Revision Counsel. 26 USC 1014 Basis of Property Acquired From a Decedent
7
Office of the Law Revision Counsel. 26 US Code 2032 – Alternate Valuation
8
Office of the Law Revision Counsel. 26 USC 1015 Basis of Property Acquired by Gifts and Transfers in Trust
9
Office of the Law Revision Counsel. 26 US Code 1031 – Exchange of Real Property Held for Productive Use or Investment
10
Internal Revenue Service. 2025 Instructions for Form 4797 – Sales of Business Property